Introduction
Under section 1202, a shareholder who sells QSBS can exclude up to 100% of the capital gain arising from the sale. Owners of an entity taxed as a partnership (including a limited liability company (LLC) electing partnership status for federal tax purposes) are not eligible for the section 1202 gain exclusion when they sell their interest. If, however, the partnership incorporates some or all of the partnership assets, the stock issued in the incorporation can often qualify as QSBS. (The incorporation can occur either via a state law incorporation or via a ‘check-the-box’ tax-only election to treat the partnership as a corporation for federal tax purposes.)
Under the section 1202 gross assets requirement, a corporation must meet the gross assets threshold up until and immediately after its issuance of stock for that stock to qualify as QSBS. The gross assets threshold is $50 million for stock issues from 1993 and until the date of the OBBBA’s enactment, and $75 million for stock issued after the OBBBA’s enactment.
The gross assets threshold generally depends on the tax basis of the corporation’s gross assets (without offsetting by liabilities). However, in the case of a partnership that incorporates, the gross assets threshold is measured by value—the fair market value (FMV) of the corporation’s gross assets (including off-balance sheet self-created intangible assets such as goodwill). Under this special rule, a corporation can fail the gross assets test even if the tax basis of its assets is zero. For a further explanation of these rules, see our article, Incorporating a partnership to obtain section 1202 eligibility.
This FMV rule is the subject of the remainder of this article. How exactly is FMV measured for purposes of this rule? In particular, how is it measured when a new investor invests cash in exchange for a portion of the company’s equity?
OBBBA’s impact on QSBS qualification
When it comes to qualification under section 1202, valuation is not just about putting a price on a business—it can make or break QSBS eligibility. As mentioned above, with the OBBBA now in play for stock issuances after July 4, 2025, the QSBS gross asset threshold jumps to $75 million, and the tiered gain exclusions kick in at 3/4/5 years (50%/75%/100%). For a deeper dive into the changes to section 1202 under the OBBBA, see our summaries, The OBBBA expands QSBS exclusions: What it means for businesses and investors and How the OBBBA’s changes to section 1202 represent opportunity for private equity. For a deeper dive into the gross asset test and other QSBS requirements generally, see our summary, Understanding the qualified small business stock gain exclusion. In short: OBBBA’s changes to section 1202 open new doors for private equity and strategic investors.
Valuation and tax considerations in rollover transactions
The fair market value of property is best determined based on an arm’s-length sale of that property (for example, trades of stock in the public markets), but in the absence of an actual sale, a valuation analysis is necessary. Unlike a FMV determination that is based on a third-party sale, however, a FMV determination based on a valuation analysis typically constitutes only an estimate of value. Moreover, there are numerous methodologies that can be used to reach that estimate, and the differential between them can be significant. Accordingly, the methodology chosen plays a critical role.
One such methodology is the ‘post-money’ methodology. A post-money equity value is often determined based simply upon the price of the last issuance multiplied by the total shares on a fully diluted basis. Is it then appropriate to take that equity value plus liabilities to come up with the section 1202 gross asset value (under the theory that assets equal equity value plus liabilities, e.g., section 338 adjusted grossed up basis)?
When a company has multiple classes of equity with different rights to distributions and proceeds, a post-money value method may actually be inappropriate, as it could artificially inflate equity value, and, thereby, gross asset value, potentially disqualifying a corporation’s stock from constituting QSBS. Instead, a more robust and detailed valuation analysis, such as based on a discounted cash flow (DCF) methodology, might provide a more accurate result, and, also, enable the corporation to reasonably assert it meets the gross assets test.
Key takeaway: Bring in valuation and tax professionals early and ask about the purpose of the valuation. How does that value impact tax and business outcomes? Is the method consistent with precedent? A post-money valuation can be performed quickly and is intuitive, but it may miss the mark for both equity value precision and asset value. A DCF approach or similar method, though assumption-heavy, can offer a more robust FMV that provides a better answer and stands up to scrutiny.
Valuation drives tax consequences, plain and simple. This is not to say that one valuation methodology is ‘right’ and another ‘wrong.’ Valuation is never an exact science—it is a blend of assumptions that drive an estimate. When looking at rollover transactions, how value is measured matters for everything from partnership capital accounting and income allocations to QSBS eligibility under section 1202. The post-money (or ‘last round’) method extrapolates from the latest issuance price and simply assumes all shares are equal in value.
Aside from being simplistic, where a company seeks eligibility as a QSBS corporation, a post-money approach could be detrimental. Using a rights-blind post-money number could push asset FMV above the $75 million threshold, jeopardizing QSBS status.
Scenario: PE investment and QSBS qualification
Picture this: An LLC has a single owner, an S corporation (S). PE then contributes $30 million to the LLC in exchange for preferred LLC units, constituting 30% of the LLC’s total units. (The transaction is treated from a tax perspective as a Rev. Rul. 99-5, situation 1 transaction.) On paper, PE owns 30% (as-converted, fully diluted), while the S corporation seller retains 70%. But those preferred units come with a twist—think ‘double dip’ preferred, with both a preferred return (e.g., 10% per year or 1.5X invested capital) and a share in common distributions. Not all equity is created equal.
Prior to electing corporate status, the LLC created initial capital accounts under a post-money methodology—$30 million for PE’s 30% and $70 million for S’s 70%. No third-party valuation is obtained. Fast forward: The owners want QSBS. Within 75 days of PE’s investment, the LLC elects corporate tax treatment post-transaction, triggering an assets-over incorporation (see Rev. Rul. 2004-59 and Rev. Rul. 84-111).
At first glance, those opening capital accounts suggest the $75 million gross asset test is not met. PE and S, however, decide to have a more detailed valuation performed, which blends various valuation methods and suggests the equity value is somewhere between $68 million and $74 million. Assuming the LLC has no liabilities, the gross asset FMV appears to equal its equity FMV. Suddenly, QSBS eligibility is back on the table.
Summary of various valuation methodologies in this scenario
- Post-money method: $100 million total (preferred $30 million, common $70 million)
- Market comparable method: $65 million total (preferred $32 million, common $33 million)
- DCF method: $70 million total (preferred $30 million, common $40 million)
- Weighted average: $68–74 million total
Comparing valuation methods
